The money supply is the total value of money available in an economy at a point of time. The government can control money supply and interest rates through a variety of tools including open market operations (buying and selling of government bonds) and changing reserve requirements of banks.(The syllabus doesn’t require you to study these in depth)
The interest rate is the cost of borrowing money. When a person borrows money from a bank, he has to pay an interest (monthly or annually) calculated on the amount he borrowed. Interest is also be earned on the money deposited by individuals in a bank.
(The interest on borrowing is higher than the interest on deposits, helping the banks make a profit).
Higher interest rates will discourage borrowing and therefore, investments; it will also encourage people to save rather than consume (fall in consumption also discourage firms from investing and producing more)
Lower interest rates will encourage borrowing and investments, and encourage people to consume rather than save (rise in consumption also encourage firms to invest and produce more).
The monetary authority of the country cannot directly change the general interest rate in the economy. Instead, it changes the rates of lending between the central bank and commercial banks, as well as the interest on its bonds and securities. These will then influence the interest rate provided by commercial banks to individuals and businesses.
Exchange rate is the rate at which one currency is exchanged for a different currency; the value of one currency in terms of another. For example: £1 = $1.2, means that one pound is equal to and can be converted to 1.2 dollars.
Monetary policy is a government policy that adjusts the interest rate and foreign exchange rates to influence the demand and supply of money in the economy. It is usually conducted by the country’s central bank and usually used to maintain price stability, low unemployment and economic growth.
Expansionary monetary policy is where the government increases money supply, cuts interests, causing exchange rates of the domestic currency to decrease (increasing demand of exports). More money supply will mean more money being circulated among the government, producers and consumers, increasing economic activity. Low interest rates will mean more people will resort to spending rather than saving, and businesses will invest more as they will only have to pay little interest on their borrowings. Economic growth and an improvement in the balance of payments will be experienced and employment will rise.
Contractionary monetary policy is where the government decreases money supply, increases interest rates, causing exchange rates of the domestic currency to increase (reducing demand of exports). Lower money supply will mean less money being circulated among the government, producers and consumers, reducing economic activity. Higher interest rates will mean more people will resort to saving rather than spending, and businesses will be reluctant to invest as they will have to pay high interest on their borrowings. This helps slow down economic growth and reduce inflation, but at the cost of possible unemployment resulting from the fall in output.
Notes submitted by Lintha
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